In the face of an increasingly reticent venture capital environment, cash-strapped companies may need to consider the possibility of conducting a down round — which, while dreaded both by VCs and leadership, allows companies to gain much needed capital, said Dean Quiambao, partner at accounting and consulting firm Armanino LLP.
As investors confront economic headwinds, many are taking much closer looks at companies’ operational metrics to ensure they show a path to growth before parting with funds. Down rounds “can be a lightning rod for CFOs to get laser focused on operational decisions,” Quiambao said in an interview.
“This can be that moment that brings everybody together and says,’ Hey, this is what we have to do to survive,” he said. “Because at the end of the day, maybe you have to have less ownership of a successful company. Well, that's better than large ownership of no company.”
Down rounds and financial buffers
A down round occurs when a private company offers shares for sale at a lower price than shares had been sold during the previous financing round, as defined by Investopedia — allowing the company to raise additional capital, but with the company discovering its valuation is lower than it was during a previous financing bid.
Since they involve that step down in valuation — as well as, typically, monetary loss for many invested in the company’s future — down rounds carry a stigma that can stick to leadership and investors and are therefore often avoided.
However, the crucial fact for CFOs and key business leaders to consider about such a round is, “when was the last time you raised money?” Quiambao said.
According to an April report by Bloomberg, 400 unicorns haven’t raised money since 2021, with economic conditions making it likely that when they do move to raise further funds, they will need to consider doing so at a lower valuation.
Despite their gloomy connotation, down rounds can enable CFOs — who should not allow trends in the fundraising community to dictate their business, Quiambao said — to get the cash influx they need to ride out economic headwinds, emerging with a path forward towards future growth.
Meta famously did a down round before they went public, Quiambao pointed out, but nowadays, nobody brings that up when discussing the company.
“So if it allows you to build the business you need or gives you the buffer that you need, don't worry about it, build the business,” he said.
Efficiency edges out potential
The need for a financial buffer comes as CFOs deal with a rapidly shifting venture capital market. When it comes to cash runway, for example, there is a little bit of “wait and see” going on among investors, Quiambao said.
“The reality is I think people are saying, ‘Okay, let's see how these companies start performing right now without the guarantee of another check,’” he said.
A May report by Carta found that the total venture capital raised by startups has dived 80% in Q1 2023 as compared to Q1 2022, while venture capital deal count dropped by 45% over that same period. Down rounds crested to their highest proportion of venture deals in Q1 2023 since 2018, making up just below 20% of all venture investments in the quarter, the report said.
It’s therefore important for startups, especially technology companies, to perform, Quiambao said. He sits on Armanino’s technology leadership team, which helps to guide strategy for its companies in the sector.
Secondly, they need to “make sure that they understand their cash runway,” he said. “Their next check is not guaranteed, especially for later stage companies.”
“Before it was almost like you could go sell the dream,” he said — nowadays, however, investors are taking deeper looks at operational metrics before they start to part with their funds.
“Can we show our plan on, how are we going to make this a long term business without needing another capital infusion, or at least show that we are hitting metrics and that if people invest in us, we think that we can continue to grow?” he said of how CFOs and business leaders need to think about investors. “I think the big takeaway here is that you still have to build a business for the long term.”
The changing valuation philosophy
As investors zero in on metrics, today’s CFOs now face the challenging task of balancing “growth at all costs to path to profitability,” Quiambao said — which requires being able to “clearly articulate” the path forward for other key business leaders, employees and investors and why in some cases, that path might need to include a down round.
“We need to articulate that, hey, this is our cash position today,” he said of CFOs. “We need to articulate that these are the metrics we're hitting, we need to articulate that this is the opportunity for our organization moving forward. And we need to articulate that this is the dollars of investment that we need for us to make that happen.”
In this changing environment, the importance many had previously placed on valuation has itself begun to wane. For example, Quiambao pointed to a recent conversation he had with a CEO, who said that his company did not have a liquidity problem, but rather, a valuation problem.
“You have all these companies that have artificially inflated values, and if they think that their next round is going to be higher than that they're wrong,” he said. “So they've got to come down, and they've got to keep building.”